Accounting 432 project 02

Author

Aftikhar Mominzada

The pond: Energy Companies Above 10B Market cap

An over view of where Valero stands in energy sector:

Conceptualizing the Ratios

A renewable energy firm might show a strong 52-week return due to increased investments in green technology, while traditional oil majors might lag during low oil price periods. Valero with PE Growth ratio of -0.37, 52 weeks total return of 15.89, and dividend yield of 3.037 is amongsts its peers like exon and chevron.

Criteria	Description
High Dividend Yield	Dividend Yield= Annual Dividend per Share /Stock Price per Share Indicates strong cash payouts to investors, appealing to income-focused investors.
Low PE Growth Ratio (PEG)	PEG = PE ratio / Earning growth Rate Implies the stock is undervalued relative to its growth potential, attractive for value investors.
Large Market Cap	Reflects stability and lower risk, often preferred for long-term investments.
High 52-Week Total Returns	This metric represents the total return (capital gains + dividends) an investor would have earned over the past year. Indicates strong price performance, attracting growth-focused or momentum investors.

Objective	Desirable Combination
Income investors	High Dividend Yield: Above the sector average. Low PE Growth Ratio: To ensure the stock isn’t overvalued. Moderate to Large Market Cap: Ensures stability and reliability of dividends. Stable or Moderate Positive Total Returns: Shows resilience without excessive volatility.
Growth investors	Low PE Growth Ratio: Indicates room for price appreciation. Moderate Dividend Yield: A bonus if growth stocks also offer dividends. Mid to Large Market Cap: Balance between potential and risk. High 52-Week Total Returns: Reflects current growth momentum.
Value Investors	Low PE Growth Ratio: A clear indicator of undervaluation. Moderate Dividend Yield: Suggests financial health and shareholder returns. Large Market Cap: Preferred for lower risk. Positive Total Returns: Avoids stagnant or declining stocks.
Momenturm Traders	High Total Returns: Reflects strong price trends. High Dividend Yield: Bonus if available alongside high returns. Low PE Growth Ratio: To avoid overvalued, overheated stocks. Market Cap May Vary: Smaller caps for higher volatility; larger caps for safer trades.

Recommendation: Valero is a Buy

After conducting a comprehensive residual income valuation of the company, it is evident that its intrinsic value is significantly below the current market price ( after adjusting for multiples). This suggests that the company is currently undervalued by the market. The key drivers of this valuation—such as the company’s steady growth prospects, reasonable discount rate assumptions, and strong return on equity—support a positive outlook for its future performance.

Given these factors, along with a favorable comparison to its industry peers, we recommend a Buy position in the stock. This presents an opportunity to capitalize on the undervaluation, assuming that market corrections align with the company’s true value in the medium to long term.

Note: We have been conservative on our approach in valuation.

Altman Zscore

Altman zscore of selected energy companies that are are above 10 Billion market cap.

Companies we will be focusing moving forward

Valero’s Z-Score of 4.90 suggests robust financial stability compared to the other companies in the list, making it a less risky investment. This is particularly important in the energy sector, where volatile commodity prices and regulatory challenges can impact operations. Valero is one of the largest independent refiners globally, with significant operational scale and efficiency. Its high Z-Score aligns with its strong balance sheet and steady cash flows from refining operations. This makes Valero more resilient to market fluctuations.

Murphy USA Inc - 7.938579004
Valero Energy Corp - 4.900304371 –> Company I will particularly focus on!
Tourmaline Oil Corp (Alberta) - 3.119163536
Canadian Natural Resources Ltd - 3.1145746
ARC Resources Ltd - 2.880749116
Cenovus Energy Inc - 2.586446485

Valero Energy Corp overview:

Valero Energy Corporation is a leading player in the oil and gas refining industry, primarily focused on manufacturing and marketing petroleum-based and low-carbon liquid transportation fuels. Founded in 1980 and headquartered in San Antonio, Texas, Valero is recognized as the world’s largest independent petroleum refiner.

Key Details:

Industry: Oil & Gas Refining and Marketing
Main Products/Services:
- Refined Fuels: Gasoline, diesel, jet fuel, and heating oil.
- Petrochemical Products: Aromatics, sulfur, and various feedstocks.
- Renewable Fuels: Renewable diesel and ethanol, with a focus on low-carbon alternatives.
Geographic Footprint: Valero operates 15 refineries across the United States, Canada, and the United Kingdom, with a combined throughput capacity of approximately 3.3 million barrels per day. The company also has a significant presence in Latin America and Mexico.

Valero’s market Segments

Valero’s commitment to sustainability is evident in its investments in renewable energy and its goal to reduce greenhouse gas emissions, making it a key player in the transition to cleaner energy sources.

Valero Energy Corporation provides segment reporting that reflects its primary business operations: Refining, Renewables, and Ethanol. These segments align with the company’s focus on producing and selling transportation fuels and petrochemical products. There has not been any change in its segment, here is a brief analysis of its segment reporting and potential strategic signals:

Segment Overview

Segment profit margin

Segment Profitability Ratio	Reportable segment	Information
	Refining	Refining segment profit margin ratio improved from 2021 to 2022 but then slightly deteriorated from 2022 to 2023.
	Renewable	Renewable Diesel segment profit margin ratio deteriorated from 2021 to 2022 and from 2022 to 2023. This is due to overall decrease in diesel consumption in north America. The projection is that renewable energy will replace a big portion of diesel consumption moving forward.
	Ethanol	Ethanol segment profit margin ratio deteriorated from 2021 to 2022 but then improved from 2022 to 2023 exceeding 2021 level.

More info about analysis of reportable segments: https://www.stock-analysis-on.net/NYSE/Company/Valero-Energy-Corp/Ratios/Reportable-Segments

Analysis of Valero’s financial statement components

Net income is consistent with operating cashflow - except 2009 and 2021 due to crashes - high net income and low OCF is not detected hence no aggresive revenue recognition.
Efficient Inventory Management: The company might have optimized its inventory management processes, maintaining just enough stock to meet demand even as revenue fluctuates. A positive sign of lean inventory practices or just-in-time (JIT) inventory systems, critical in energy business.
Accounts Payable and Revenue are aligned, no sign of delayed payment.
There is nothing abnormal about essential components of income statement and CF that stop us from continuing our evaluation.

ROE

We are comparing changes in growth of Valero to its peers in the same industry becuase it provides context to assess whether the company’s growth or decline is typical for the industry or signals outlier behavior. It is necessary given the rapid change in energy sector and transition to renewable energy.

Regression of ROE with time, if there is a relationship we can use it to project the next 8 quarters. The sudden drop of ROE in 2024 is a by product of transition into renewable energy. As we can see it was expected and Valero’s ROE is not behaving differently than its peers.

Deconstructed the ROE in trend, seasonal, and remainder components. There is trend present in our ROE over long period which means there is room for prediction.

Use of ARIMA to forecast the next 8 periods of ROE. Essentially cleaned the noise and focused on actual growth in ROE.

Valero Energy and Canadian Natural Resource ROE will grow. While it is a good new energy revenue and income in energy sector is highly cyclical.

Dupont Analysis: ROE:

Asset turnover: Valero is the second highest and consistent which means it is effective at managing its costs and generating profit from its sales. the best compared to all the companies due to its relative consistency.

Net Margin percentage: Valero has lowest net margin however it is consistent compared to its peers, it is very impressive given the cyclical nature of energy sector. It means investors seeking stability should pick Valero.

In a cyclical industry like energy, where profit margins typically fluctuate due to external factors (e.g., commodity price volatility, supply-demand dynamics, geopolitical events), a stable net margin is a significant indicator of the company’s resilience and operational strength.
The company likely has excellent control over its operating and production costs, allowing it to maintain profitability even during downturns in the industry.
Suggests geographical diversification and involvement in non-cyclical areas like renewable energy or energy services, which help buffer against volatility.

Equity Multiplier (asset/equity): Valero has similar leverage as compared to is peers, means it uses similar level of debt to finance its assets.

Overall ROE: Amongst its peers

Valero’s forecasted WACC on equity

WACC is a suitable rate for energy companies like Valero due to following reasons:

Energy companies typically rely on debt for large infrastructure investments and equity for long-term projects.
Energy companies operate in a capital-intensive and cyclical industry, with risks like fluctuating oil prices, geopolitical uncertainties, and regulatory changes.
Valero’s refining and marketing operations are tied to market dynamics, and WACC captures the expected return investors and lenders require to finance these cash flows.
Using WACC ensures that decisions account for both the fixed debt costs and the variable equity costs, which reflect changing market conditions.

Valero has the lowest WACC compare to its peers and has been decreasing rapidly.

It is valuable to us for the following reasons:

A lower WACC indicates that the company can finance its operations and growth at a lower cost. A decreasing WACC signals to investors and creditors that the company is becoming less risky and more stable. It may attract more investment at lower rates, giving it a financial edge over competitors. Also a stable or decreasing debt-to-equity ratio also minimizes perceived financial risk. This could result from lower borrowing costs, reduced risk, or increased investor confidence. If Valero’s stock volatility decreases or investor confidence improves, the required return on equity diminishes, reducing WACC.

The revenue of energy companies specially refinaries is directly related to production volume of crude oil and highly sensitive to crude oil prices. Companies mitigate this dependence through diversification, refining operations, and hedging strategies, but production remains a key revenue driver.

Regression between changes in oil production and changes in revenue:

Company	Energy type
Canadian natural resource	Crude oil, Natural Gas, Bitumen
Suncore	Crude, Refined petrolum, Renewable
ARC	Natural gas
Valero	Refined products (Gasoline, diesel, jet fuel, petrochmicals) Ethanol. Down stream company maingly focusing on refining crude oil - directly connected to crude oil.
Cenovus	Crude oil, Natural gas

Valero stands out with the highest R-squared and statistically significant slope. As a downstream-focused company, its operations are more directly linked to production volume than external crude oil prices. This stability comes from processing crude oil into refined products, where demand fluctuations for end products are less volatile than crude oil prices. Given that Valero’s downstream operations, makes its revenue highy sensitive to Crude oil production level, as evident by the significant slope and R-squared. While Valero has the highest R-squared, 32.8% still leaves a significant portion of revenue variability unexplained. It makes sense because the company operates in 3 different segments that covers for the rest ~67.2%.

For each percentage increase in oil production Valero’s Revenue increases by 2.7%. With confidence level of 97.44%. There is a steady growth in revenue of Valero projected which directly impacts its net income.

Residual income model: firms value!

Formula	Explanation

Firm Value = Book Value of Equity + Residual Income / (CAPM - Composite Estimated Growth Rate)

Quarterly book value of equity is used along with quarterly residual income.

Residual Income = Net Operating Income after tax - (CAPM × Shareholder’s equity (previous period))

Normalized net operating income after tax is used along with quarterly shareholder’s equity from the previous period.

r = Rf + B × (Rm - Rf)

Valero’s observed quarterly beta is used along with the 1-year treasury rate observed quarterly. S&P500 quarterly return is used as return on market.

The formula assumes a perpetuity model, which is appropriate if the firm is expected to operate indefinitely with steady-state growth. However the model adjusts itself every quarter, which brings more accuracy to this valuation. From the graph bottom left, shareholders’ equity remains relatively stable while firm value based on RI model fluctuates around it (values are in billion). As you will see in coming paragraphs, the ratio between the two on average remains 1.78. In other words there is consistency and essentially the volatility is noise/could be used by market participants to take advantage (buy low sell high). In the bottom right corner, blended growth rate is taken from refinitive and it is the such as historical growth and forecasted growth, to produce a more comprehensive estimate of a company’s future performance. This rate is often used in valuation models, such as Discounted Cash Flow (DCF) analysis, to estimate the long-term growth rate of a company. In my case I used it to forecast the growth in residual income. In the context of discount rate it is note worthy to mention that although it is volatile there is no trend. We will so in more detail why it makes sense. (Values are in billion for SE and RI).

Growth Rate vs. Discount Rate Trend

Observation: We cannot come up with one single value for growth rate or discount rate. However, on average the growth rate of the firm is increasing faster than the discount rate.

Implications:

Valuation Impact: A higher growth rate relative to the discount rate (i.e., g > r) reduces the denominator (r - g) in the valuation formula, increasing the present value of future residual income. This can significantly raise the firm’s intrinsic value.

Investor Sentiment: Investors typically perceive a higher growth rate as a positive indicator of the firm’s future earnings potential, enhancing demand for the stock. The stock price trajectory provides external validation for the intrinsic valuation model based on residual income: an increase from $55 /Per share –> to $162/per share in 4 years.

Historical Context: it highlights how this trend aligns with historical performance (steady and growing), suggests consistent earnings growth, successful reinvestment strategies, and favorable industry conditions (ie entering renewable energy market)

Valuing the company

Here we are assuming the growth rate is not increasing and is constant, the same with discount rate. If we take the average of past 6 quarter residual incomes and use growth rate and discount rate on it we will get an Book value of equity as 33.14 Billion . We assumed that residual income will grow for the next 10 period and will stop growing afterwards (despite growing nature Valero, we are being conservative in our approach.) The current market value of Valero is 44.26 Billion at 11/25/2024.

   Period Discount_rate Growth_rate Residual_incomes
1       1      1.061222  0.77850183       2241464568
2       2      1.126191  0.60606510       1644316520
3       3      1.195139  0.47182279       1206254542
4       4      1.268307  0.36731490        884896553
5       5      1.345955  0.28595532        649151470
6       6      1.428356  0.22261674        476211180
7       7      1.515803  0.17330754        349343871
8       8      1.608603  0.13492024        256275253
9       9      1.707084  0.10503565        188001023
10     10      1.811594  0.08177045         36742093

Total Value: $ 33140385572

Based on past 35 fiscal quarter observations the average ratio between Market cap/ book value of equity is 1.778396537

Based on a book value of $33.14 billion, the market capitalization should be $58.94 billion. However, the current market cap stands at $44.26 billion. Given that the energy market is cyclical, fluctuations in the market directly affect sentiment and, consequently, the valuation of energy companies. My assumption is that Valero is currently at the lower end of its valuation range. As market conditions improve, its intrinsic value is expected to rise, leading to an increase in its market capitalization.

# A tibble: 6 × 3
  date       `firms value RI model` `Company Market Capitalization`
  <date>                      <dbl>                           <dbl>
1 2023-06-30           24792571537.                    51350484382.
2 2023-09-29           56630290788.                    42405938118.
3 2023-12-29           19760337503.                    50042460425.
4 2024-03-28           19128659019.                    44258882460 
5 2024-06-28           25586217508.                    56234507186.
6 2024-09-30           21133507770.                    51259952999.

Despite predicting Valero’s revenue growth, my attempt to forecast its income using regression analysis did not yield satisfactory results. A key challenge in this process is that Valero operates across three distinct segments, with crude oil not being its sole revenue driver. Additionally, the renewable energy segment, still in its infancy, introduces significant uncertainty regarding future demand, further complicating accurate income projections.

# A tibble: 2 × 5
  term                                      estimate std.error statistic p.value
  <chr>                                        <dbl>     <dbl>     <dbl>   <dbl>
1 (Intercept)                                5.99e+8   3.09e+8      1.94  0.0612
2 valero_data$`Revenue from Business Activ…  6.21e-3   3.74e-3      1.66  0.106